Analysis: Air India’s $1 billion compensation claim on Boeing for 787 delays is baseless

Earlier this week, reports surfaced that India’s national carrier Air India was asking for roughly $1 billion in compensation from US original equipment manufacturer (OEM) Boeing for the roughly 3 year delay of the Boeing 787-8.

With Air India’s initial delivery having been pushed back almost 2.75 years by the natural program delays and further delay of the delivery of Air India’s 787s into early 2012 because of a failure to complete the final certification requirements of the General Electric GEnx-1B engines with the United States Federal Aviation Administration (FAA), Boeing is certainly culpable for these delays. Air India will be the first airline to receive GE-powered 787s, with multiple 787-8s featuring Rolls-Royce’s competing Trent 1000 already plying commercial flights around the globe.

However, when Air India first signed a contract for the 787-8, compensation was capped at 0.5% of the order’s list value, which at that time roughly $3.24 billion due to under-pricing of the 787 by Boeing (it was priced at $120 million then, now at $193.5 million). This would translate to a cap on compensation of $162 million. Of course Boeing naturally had to soften this stance given the image problems created by the 787 delays, even offering about $500 million in compensation.

However, the fact remains that $1 billion in compensation is far, FAR too much for Boeing to have to pay. Air India’s economic losses on the 787 delays are far from $1 billion, as the following analysis should indicate, and as such, we feel that Air India is completely out of line in asking for this much money to pump into their black hole of an operation.

Please consider a few things before reading this analysis. Firstly, these are “back-of-the-envelope” calculations, so to speak; they do not represent Air India’s internal analyses but rather the best “apples-to-apples” estimates we could come up with. Secondly, these are highly optimistic projections, utilizing best case scenarios. Thirdly, the origin of the operating cost data is from my report “Hot Air- The Mid Sized Widebody Race in Early This Decade,” a copy of which can be purchased at Air Insight’s online store for US$ 49 (INR 2,500). I cannot share more details of this data as it would violate certain NDAs and represent conflict of interest between my various ventures.

With all of that being said, here are the major assumptions present in this analysis. The 787-8 is projected to meet all range targets and is thus able to make Chicago/Toronto-Delhi nonstop in both directions with a full passenger load. Air India was to receive 20 787s over the first 3 years of the program; this is an estimate based off the timeline for the delivery of their first seven 787-8s (VT-ANA through ANH) outlined in early December. We are choosing to ignore the fact that Air India was in fact moving to defer their own 787 deliveries by two years in 2009 before being “bailed” out by Boeing’s delay, which would invalidate both this analysis and Air India’s claims. Because the 787 deliveries are staggered, we are projecting that the average of 20 787-8s will only occur in Air India’s fleet only over the last two years of that period and thus we are amortizing the net loss over 2 years.

Based on extensive research of Air India fares over the next 6 months, we have estimated the following typical yield mixes for Air India’s 3 cabins; $234 per flight hour for first class, $136 per flight hour for business class, $67 per flight hour for economy class. In each case, we are assuming 75% loads for first class, 80% loads for business class, and 85% loads for first class to calculate lost revenue potential (rounding to the nearest passenger for each case). We feel comfortable in making these assumptions because Air India has a relatively price inelastic customer base: they charge roughly the same fare for each class on both the 777-200LR and 777-300ER on the same route (where there are aircraft swaps) despite the 777-300ER having 43.7% more seats.

There are two models through which we can measure the impact of the 787 delays on Air India’s finances over the past two years. The first is the replacement model, under which the 20 787s would directly replace the 777-300ERs and the 777-200LRs. These two fleets combined for Air India have an average daily utilization of about 11 hours per day in summer 2012, and as such are similar to Air India’s projected 11.78 hours per day total utilization of the 787-8s denoted in the RFP for sale-leaseback from December. Under this model, the cost to AI comes from the lost savings of the 787-8 vs. the 777s net of the lost revenue potential, plus the (very small) marginal benefit of having the passenger friendly and reliable 787-8 in their fleet.

Utilizing this model, we first turn to the 777-300ERs, which have average daily utilization of roughly 9 hours per day, multiplied by 12 aircraft in the fleet for 108 hours per day. Under our estimates, the 777-300ER is on average (for Air India’s routes) $7600 less efficient than the 787-8 per flight hour. Under Air India’s configuration however, the aircraft has 4 more first class seats, 17 more business class seats, and 65 more economy class seats. Under our projected loads, that represents an advantage of 3 first class, 14 business class, and 55 economy class seats. This translates to $6291 of lost revenue potential, which creates a net loss of $1309 per flight hour. Spreading that over 108 flight hours per day over 2 years translates to a net loss of $103.2 million.

Moving to the 777-200LR; this aircraft has 8 more first class seats, 17 more business class seats, and 43 fewer economy class seats. It also costs $5000 more to operate per hour than the 787-8. Under our load factor assumptions, this represents 6 more first class seats, 14 more business class seats, and 34 fewer economy class seats. Thus, the lost revenue potential is just $963 per flight hour, yielding a net loss of $4037 per hour. Spreading that over the 14 hours of daily utilization for 8 aircraft or 112 hours of daily utilization, the net loss over 2 years is $330.1 million.

Summing the costs of these two brings us to $433.3 million, or close to the sum initially offered by Boeing. Given the cascade of bad news that has overcome Air India over the past 3 years, it’s not impossible to tack on another $70 million or so to account for the rising costs of negative customer perception and interest fees on accumulated losses, bringing us essentially to a nice round figure of $500 million.

The second model that we can use is a model of lost revenue/opportunity. Under this model, Air India (as it has for the most part indicated it plans to do) would use the 787-8s primarily for expansion. Thus the cost to Air India of the delay is simply the lost profitability of the 787 (revenue per flight hour minus cost per flight hour), plus the marginal loss of flow traffic (connections) and potential frequent flyers (who might have jumped over to Air India with the new routes).

This model poses a set of unique challenges, however, the first being that it’s hard to find the requisite 236 hours of daily utilization or so that would be required to meet Air India’s projections. That being said, we’ll assume that they do in fact operate these flights and this utilization.

In terms of yields, there will be some drop off due to the added capacity. In terms of the true addition of capacity, Air India’s utilization figures from the RFP indicate that 20 787s would add about 4.4 million annual seats to Air India’s network. From a perspective of Air India’s network, that represents about a 26% increase in seat capacity (measured in available seat miles). Using a consensus of estimates of the price elasticity of demand for air travel and Air India’s unique demand streams, we’ll allow Air India the benefit of the doubt for this exercise, and build in just a 15% drop in yield for Air India (smaller in magnitude than the increase in capacity). Under our model, this would mean that business class yields were $116 per flight hour, and economy class yields were $57. Under this model, the sudden rise in capacity also would decrease load factors by just 5 percentage points in each class; to 75% in business class and 80% in economy class. Under these conditions, the 787-8 would have 14 business class seats filled, and 190 economy class seats filled.

With average cycle length of 5 hours and average annual utilization of 4300 hours, the 787-8’s operational profitability under the conditions denoted above would thus be roughly $119 million over the two years. This operational profitability is a best case scenario (and hard to envision given Air India’s current status of not even covering costs of fuel on some long haul flights), and does not include the financial costs (lease rates and/or depreciation) of operating the aircraft.
Building in $100 million for the effects of increased flow traffic through Delhi and Mumbai, as well as another $50 million for the effect of increased frequent flyer retention (both very generous estimates), plus $100 million for all other effects, including increased negative customer perception and accumulated losses (and the resultant interest charges). Even adding up these highly optimistic charges, we still reach a sum of $469 million, less than the sum Boeing has offered.

So it should be abundantly clear that Air India has very little basis to claim $1 billion in compensation. It would appear rather, that a carrier who is seeking a $6 billion bailout from the Indian government to fund loss-making operations from the next decade is simply looking to soak Boeing for more cash (funding a whopping 1 year more of Air India operations) so as to slightly delay the timing of their next bailout, which we can be sure will at least double in size. Air India is building off of the baseline of other, profitable, carriers who have valid claims for compensation from Boeing, but should not be allowed to do so.

As Devesh pointed out last week, Air India’s proposed bailout of 30,000 crore could feed all of India’s hungry (231 million people, or close to 20 times Air India’s annual passenger base) for more than one year. The best solution for Air India is to simply accept the more than generous $500 million offered by Boeing and allow the OEM to focus its cash on improving the 787-8 further, perhaps cutting Air India’s future losses and distributing the savings to the hungry.

About Vinay Bhaskara

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